European Economic Community

[Editor's note: the European Economic Community has evolved a good bit since this article was written in 1992.]

The vast majority of economists agree that trade, by allowing specialization, enhances efficiency. But as Adam Smith observed, the division of labor (the degree of specialization) is limited by market size. International trade is an obvious way of increasing market size.

Since World War II, countries have reduced barriers to trade mainly through multilateral negotiations such as the General Agreement on Tariffs and Trade (GATT). A central premise of the GATT is nondiscrimination: countries should give all GATT members the same access to their markets. The main exemption to that rule is free trade areas. Partners to free trade agreements are allowed to exempt one another's goods from import duties while maintaining tariffs and/or quotas on products from other GATT countries.

The European Economic Community (EEC), the most prominent example of a free trade area, actually is what economists call a customs union. Whereas member nations in a free trade area remove all barriers to trade among themselves, in a customs union they also adopt uniform tariffs on goods and services from outside the union. The EEC is currently attempting to transform itself from a customs union to a true common market in which capital and labor, and not just goods, are allowed to flow freely from one country to another.

The EEC's impact has been significant. In 1960 more than 60 percent of the trade of the Community's twelve members was with other parts of the world. Now more than 60 percent stays within the European grouping. Where the EEC contented itself initially with removing internal barriers to trade, it has since expanded into the regulation of domestic markets and monetary unification.

Origins

The European Community is an amalgam of three separate communities: the European Coal and Steel Community, established by the Treaty of Paris in 1951 to regulate production and liberalize Europe's trade in coal and steel products; the European Atomic Energy Community, formed by the Treaty of Rome in 1957; and the European Economic Community, also created by the Treaty of Rome. All three were established to encourage political and economic cooperation among member countries, notably France and Germany, that had repeatedly warred with each other. By 1967 the institutions of the European Economic Community (or Common Market) became common to all three communities. Today it is conventional to refer to the European Community (aka the EC or the Community) in the singular, whether one means the Economic Community or all three initiatives.

The EC initially consisted of six Western European nations—Belgium, Luxembourg, France, Italy, the Netherlands, and West Germany. Britain, Ireland, and Denmark were admitted in 1973. Three southern European countries were allowed to join once they installed democratic governments—Greece in 1981, Spain and Portugal in 1986. Other Western European countries (Austria, Finland, Sweden, and Switzerland) belong to the European Free Trade Association, or EFTA (as did Britain, Ireland, and Denmark before 1973). EFTA has traditionally concentrated on trade liberalization, in contrast to the EC's more ambitious agenda of economic and political integration.

Development

The EC's most important achievement has been its customs union. It was completed in 1968, when each of the six members abolished tariffs and quotas on goods from the other five member countries and adopted a common external tariff on goods from the rest of the world. The evolution from a free trade area to a customs union followed inevitably: had the participants maintained different external tariffs, exports from, say, Japan could have been imported through the low-tariff countries and transshipped to the others, circumventing the high tariffs. The customs union has propelled the growth of intra-Community trade from less than 40 percent to over 60 percent of the total trade of the participating countries.

As Jacob Viner pointed out in a classic analysis of trade, whether the participating countries benefit from their customs union depends on whether it creates additional trade or simply diverts trade away from the rest of the world. If EC countries continue to import petroleum from the Middle East, wheat from the United States, and stereo equipment from Asia but specialize further in their own production—if, for example, instead of producing both beer and wine, the British produce beer, the French produce wine, and they trade freely with one another—then trade is created and living standards rise. But if EC members now buy expensive German barley rather than cheap American wheat because of high external tariffs or low quotas, trade is diverted and European consumers are left worse off.

Which effect dominates depends on how similar the customs union participants are to one another. If similar, they will tend to produce many of the same things, and when internal trade barriers are removed, the additional imports will be items that the other participants produce even more efficiently than both the importing country and the rest of the world. Trade creation will dominate. But if the customs union participants have very different economic structures and specializations, damaging trade diversion may dominate instead.

To the naked eye, the twelve EC members resemble one another economically more than they resemble the rest of the world. It is not surprising, then, that most studies conclude that the European Community is a trade-creating customs union. But the benefits are surprisingly small, typically less than 1 percent of national income, or only five months' normal economic growth.

Why so small? One explanation is that these simple calculations miss dynamic gains from trade. Exposed to the chill winds of intra-European trade competition, European producers will work harder to come up with a better mousetrap. Innovation and productivity growth are thereby stimulated, producing growing efficiency gains over time. Another possibility is that the small estimate is correct, because the larger benefits potentially available are destroyed by the Community's Common Agricultural Policy (CAP). The CAP allows free trade in high-priced agricultural goods within the Community by excluding potential low-priced imports from outside. Community countries subsidize the domestic production of agricultural goods despite their comparative disadvantage. Consumers pay high prices as the twelve member countries collude to maintain trade-diverting tariffs on cheap imports from the rest of the world.

Thus, the CAP and the customs union show the two faces of the European Community, one that enhances efficiency by promoting competition and specialization, and one that sacrifices economic efficiency to help farmers.

The Single Market Program

In the eighties Western Europe suffered from persistent high unemployment. Productivity growth lagged behind other parts of the industrial world. The popular diagnosis was that Europe was suffering the effects of excessive government regulation and from the fragmentation of European labor and capital markets into a series of inefficiently small national markets. The disease was dubbed "Eurosclerosis," and the prescription, known as the Single Market Program, was a Community-wide initiative to deregulate and integrate national markets.

The Single Market Program was set out in a white paper published by the European Commission in 1985. It recommended nearly three hundred measures to remove obstacles to intra-European competition. The Single European Act (SEA) of 1986 committed EC members to implement those measures by the end of 1992.

The SEA will affect Europe's every nook and cranny. Trucks hauling merchandise will no longer have to stop at the border between EC countries, except for health and safety inspections. Governments may no longer discriminate in procurement or in awarding public works contracts. Every European country will have to recognize the product standards of the others. Remaining barriers to the movement of capital and labor across the EC's internal frontiers will be removed. EC residents will be able to shift their funds from one country to another without having to worry about capital controls, and will be able to work in another member country without having to secure a work permit or obtain local technical accreditation. National tax codes will be harmonized to simplify economic decision making.

Economic analyses suggest that the benefits are likely to be considerably larger than those derived from the customs union alone. The downside, however, is that regulation may well become more oppressive because the influence of intercountry competition, which tends to discourage costly regulation, is eliminated. Similarly, the harmonization of tax policy will prevent footloose factors of production (i.e., labor and capital) from fleeing to low-tax jurisdictions, thus removing an important constraint on spending by national governments.

Monetary Unification

In 1988, with European integration gathering momentum, the governments of the EC member states appointed a committee, chaired by Jacques Delors, president of the European Commission, to study the feasibility of complementing the single market with a single currency. After the Delors Report appeared, the EC governments appointed an Intergovernmental Conference to prepare amendments to the Treaty of Rome. The proposed amendments—the Treaty on Economic and Monetary Union—were presented at the Dutch town of Maastricht in December 1991.

The Maastricht Treaty proposes replacing the EC's twelve national currencies with a single currency and creating a European Central Bank (ECB). These goals are to be achieved in three stages. Stage I, which began in July 1990, is marked by the removal of capital controls (as already mandated by the SEA) and attempts to reduce differences in national inflation and interest rates and to make intra-European exchange rates more stable. In Stage II, to start in January 1994, national economic policies will converge further and a temporary entity, the European Monetary Institute, will coordinate member-country policies in the final phases of the transition. If the Council of Ministers, made up of ministers of economics or finance from each national government, decides during Stage II that a majority of member countries meet the preconditions for monetary union, it may recommend that the Council of Heads of State vote to inaugurate Stage III, establishing the ECB and giving it responsibility for monetary policy. To prevent Stage II from continuing indefinitely, however, the treaty requires the EC heads of state or government to meet before the end of 1996 to assess whether a majority of EC countries satisfy the conditions for monetary union. Stage III will begin in any case no later than January 1, 1999. In this case, Stage III may proceed with only a minority of EC countries participating.

When Stage III begins, exchange rates will be irrevocably fixed. The ECB will assume control of the monetary policies of the participating countries. It will decide how and when to replace the currencies of the participating countries with the new European currency. It may do so on the first day of Stage III, or it may instruct its operating arms, the national central banks, to intervene to stabilize the exchange rates among their national currencies until these are replaced by a single currency.

Monetary integration is more controversial than the Single Market Program. Denmark rejected the Maastricht Treaty in its June 1992 referendum, and France nearly did the same three months later.

No one questions that there are benefits from using one currency instead of twelve. For one thing, a single European currency will save on transactions costs: the EC's economists estimate the savings at 1 percent of EC GNP. And removing the uncertainty created by exchange-rate fluctuations will encourage additional intra-European trade and investment.

There is, however, no free lunch. Forcing all European countries to run the same monetary policy and to maintain the same interest rates will deprive Europe's national governments of a policy tool traditionally used to address their own macroeconomic problems. When Italy has had a recession not shared by other EC countries, its central bank (the Bank of Italy) has reduced interest rates, expanded the money supply, and devalued the exchange rate, with the goal of boosting domestic demand and moderating the recession. With no exchange rate to devalue and with monetary policy turned over to the ECB, this response will no longer be possible. Europe had a taste of this problem in 1991 and 1992, when high interest rates in Germany, together with the fixed exchange rates of the European Monetary System that already tied European monetary policies together, drove interest rates up throughout the EC.

As this experience reminds us, a monetary policy common to all twelve EC countries will be useful for moderating only those business cycle fluctuations that are common to the twelve countries. Insofar as European countries experience cyclical expansions and contractions at different times, their sacrifice of monetary autonomy may cost them a lot.

About the Author

Barry Eichengreen is the George C. Pardee and Helen N. Pardee Professor of Economics and Political Science at the University of California at Berkeley, a research associate of the National Bureau of Economic Research in Cambridge, Massachusetts, and a research fellow of the Centre for Economic Policy Research in London. He wrote this article while visiting the Institute for Advanced Study in Berlin.

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